Kevin Read warns that we may be heading for very high tax charges on undrawn pension funds.
It is standard inheritance tax (IHT) planning to write death benefits payable from money purchase (defined contribution) pension schemes into trust for one or more nominated beneficiaries (usually family members). Under current rules, this puts them outside the IHT net if the policyholder dies.
At the Chancellor’s Budget on 30 October 2024, the government announced the intention to remove this IHT exemption from 6 April 2027.
NB. These changes will have no effect on defined benefit (e.g., final salary) pension schemes.
Pension death benefits
Under pension tax rules:
-
if the deceased was aged 75 or over, any benefits drawn are fully taxable at the recipient’s marginal income tax rate; or
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if the deceased was aged under 75, benefits drawn in excess of the death benefit lump sum allowance (DBLSA) are taxable at the beneficiary’s marginal rate.
The DBLSA caps the amount taken tax-free in aggregate during the individual’s lifetime and on death, thus taking account of any tax-free pension commencement lump sums that have been taken. The DBLSA is set at £1,073,100 (for 2025/26) but may be increased where any of several ‘protections’ has previously been claimed.
Example: Louisa cannot pass on most of her pension fund
Louisa, a widow, dies aged 81 in June 2027. She leaves her house (value £900,000) and other assets worth £1.1m to her only son. When her husband died, he had left everything (including a half-share of the house) to her.
Louisa also has an undrawn defined contribution pension worth £800,000. Her nominated beneficiary is her son, who is a higher-rate taxpayer.
Under the proposed changes, her chargeable estate will include the pension rights, so it will total £2.8m. Thus, no residence nil rate bands will be available, as they are fully tapered away once the value of the estate goes above £2,350,000.
The IHT liability on this estate is calculated as follows:
£
On first £650,000 @ 0% –
On next £2,150,000 @ 40% 860,000
This average estate rate is £860,000/2,800,000 x 100 = 30.7143%, which will be used to split the IHT proportionately, as follows:
£
Personal representatives 614,286
Pension scheme administrators 245,714
860,000
If Louisa had died before the changes were implemented, her chargeable estate would have been £2m and there would have been no restrictions on the RNRBs. The IHT liability would have been:
On first £1m @ 0% –
On next £1m @ 40% £400,000
Effective tax rate on the pension pot £
Additional IHT (£860,000 - £400,000) 460,000
Income tax on drawdown by son of residual pension
(£800,000 – £245,714 = £554,286 @ 45%) 249,429
709,429
Effective tax rate: £709,429/£800,000 = 88.68%!
IHT planning going forward
With death benefits written into trust, it is currently common practice to live off other savings (e.g., shares or cash savings) and let the pension fund pass on death. This policy is likely to be reversed once these changes are implemented, as people will be encouraged to draw pension income to live off and leave other assets in their death estate, in order to avoid these high tax rates.
In many cases, taking money out of a pension pot (where the individual has other resources available) will allow the pension scheme member to make use of the exemption (IHTA 1984, s 21) for regular gifts out of surplus income, if that money is then given away (e.g., to family members).
Practical tip
Taking a 25% tax-free lump sum from a pension pot will become even more valuable once these changes are implemented.
